The Treasury Auction Shell Game

Very few people have either the time or patience to sift through the data released by the Treasury Department in the wake of its bond auctions. But the numbers do provide direct evidence of the country's current financial condition that in many ways mirror a financial shell game that typifies our entire economy.

Despite continued deterioration of America's fiscal health, the Treasury is still attracting adequate numbers of buyers of its debt, even with the ultra low coupon rates. Market watchers take these successful auctions as proof that our current monetary and fiscal stimulus efforts are prudent. But who's doing the buying, and what do they do with the bonds after they have been purchased?

Most people are aware that foreign central banks figure very prominently into the mix. They buy for political reasons and to suppress the value of their currencies relative to the dollar. And while we think their rationale is silly, we do not dispute that they will continue to buy as long as they believe the policy serves their own national interests. When that will change is harder to determine. But another very large chunk of Treasuries go to "primary dealers," the very large financial institutions that are designated middle men for Treasury bonds. In a late February auction, these dealers took down 46% of the entire $29 billion issue of seven year bonds. While this is hardly remarkable, it is shocking what happened next.

According to analysis that appeared in Zero Hedge, nearly 53% of those bonds were then sold to the Federal Reserve on March 8, under the rubric of the Fed's quantitative easing plan. While it's certainly hard to determine the profits that were made on this two week trade, it's virtually impossible to imagine that the private banks lost money. What's more, knowing that the Fed was sure to make a bid, the profits were made essentially risk free. It's good to be on the government's short list.

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Given that the Treasury is essentially selling its debt to the Fed, in a process that we would call debt monetization, some may wonder why it doesn't just cut out the middle man and sell directly. But the Treasury is prevented by law from doing this, so the private banks provide a vital fig leaf that disguises the underlying activity and makes it appear as if there is legitimate private demand for Treasury debt. But this is just an illusion, and a clumsy one to boot.

One wonders how the market could be soothed by these results when they are so clearly manipulated. But the more important question is when the foreign governments reverse their currency policies, and when the investment banks are no longer guaranteed a quick short term profit, will there be anyone left willing to show up at Treasury auctions?

According to the Office of Management and Budget, the U.S. government is expected to run a $1.6 trillion deficit in fiscal year 2011 (which expires in September). The Federal Reserve's current quantitative easing program is taking down a large share of that red ink. But "QE2" expires in July, and in fiscal year 2012, the Federal government is projected to run a $1.1 trillion deficit (that of course could grow if the economy weakens). An additional $1.1 trillion in Treasury notes and bonds will mature over that 12 month period. So in total, the Treasury will need to issue a total of at least $2.2 trillion in notes and bonds in FY 2012. This translates into quarterly borrowing needs of approximately $550 billion, more than double the average of the last two quarters. To put this into perspective, the entire U.S. personal savings rate is about $650 billion annually. Even if every dime of this amount were ploughed into Treasuries, we would still need to borrow or print another $1.6 trillion.

At the height of the financial crisis in Q4 2008, the Treasury issued a record $560 billion of notes and bonds. Fortunately for them, that spike corresponded neatly with huge inflows of funds into Treasuries as investors sought safety from collapsing equity and corporate debt markets. Will the Treasury catch that break once again? There may be another financial panic, but will investor reaction be the same this time around? Bill Gross, the founder and chief investment officer of PIMCO, the world's largest private purchaser of bonds, recently announced that he is reducing his Treasury holdings to zero. It is not clear what would convince Gross to get back into the market with both feet, but one might expect at minimum it would take much higher interest rates.

If private investors stay on the sideline, how does anyone expect the Treasury to sell its inventory without the support of a quantitative easing program from the Fed? Do they expect the Chinese to reverse course on their current policy and start heavily buying U.S. debt once again, irrespective of the damage to their own economy? That seems extremely unlikely given the drift in Chinese currency policy. More likely the Fed will remain the only buyer, meaning QE3, 4, and 5, are all but certainties. There should be no remaining doubts…the U.S. Government intends to monetize its own debt. Of course, as bad as things will be if QE ends, it will be that much worse the longer it continues.

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